INFLATION & EXCHANGE RATE

DYNAMICS

Inflation and Exchange Rate Dynamics

InflationA situation where an economy’s price level

rises. Deflation

A situation where an economy’s price level falls.

Inflation and Exchange Rate Dynamics:

Short-Run Price Rigidity versus Long-Run Price Flexibility

Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, 1974-2001

Inflation and Exchange Rate Dynamics

A change in the money supply creates demand and cost pressures that lead to future increases in the price level from three main sources:○ Excess demand for output and labor○ Inflationary expectations○ Raw materials prices

Inflation and Exchange Rate Dynamics

Effects of an Increase in the U.S.Money Supply

Inflation and Exchange Rate Dynamics

Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply

Inflation and Exchange Rate Dynamics

Exchange Rate OvershootingThe exchange rate is said to overshoot

when its immediate response to a disturbance is greater than its long-run response.

“Overshooting” helps explain why exchange rates move so sharply form day to day.

“Overshooting” is a direct result of sluggish short-run price level adjustment and the interest parity condition

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